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Why American Express Gave Costco the Boot (and Not the Other Way Around)

After Costco pushed for a change in terms, American Express concluded that the deal no longer made economic sense.

Ever since American Express(NYSE:AXP) announced that it will no longer be the exclusive credit card accepted at Costco(NASDAQ:COST), most analysts and commentators have portrayed the decision as an unmitigated disaster. But that's not a fair interpretation of what actually happened, or of the commendable restraint exercised by American Express' executives, given the unpopularity of the move.

The reality is that America Express walked away from the deal after Costco, in a manner perhaps not unlike the way it squeezes its suppliers' margins, sought to change the terms of the partnership in ways that threatened to upset the delicate balance between the credit card portfolio's risk and return. None of us know exactly what the new terms are, of course, but I trust American Express CEO Kenneth Chenault when he says they didn't make "economic sense for us and our shareholders."

The peculiarities of credit cardsTo understand why American Express would walk away from a deal that accounted for an estimated 10% of its outstanding credit cards, it's important to keep one thing in mind -- namely, that credit card loans are the riskiest types of loans that exist. In this year's stress test, the Federal Reserve projected that 13.1% of credit card loans would result in losses if the economy were to experience another downturn akin to the financial crisis. That loss rate is nearly 50% greater than the next riskiest category, commercial real estate loans, and almost four times that of first-lien residential mortgages.

There are two reasons for this. The first is that a credit card is much easier to get than, say, a home loan. In the latter case, you have to provide your financial statements, submit to a credit check, and make a non-negligible down payment. In the former case, all you have to do is fill out some perfunctory paperwork designed to expedite the process. It follows that many people who probably shouldn't have access to credit are nevertheless able to get it by qualifying for a credit card.

The second reason is that credit card loans are unsecured. Unlike a mortgage, they're not backed by specific, identifiable collateral. When a credit card loan defaults, there's no property that's automatically seized and sold to mitigate the loss. To put it in financial terms, the "loss severity rate" of unsecured loans is much higher than that of secured loans.

Balancing risk and rewardThis isn't to say that credit card loans can't be profitable, because they can be. American Express generated a remarkable 29% return on equity in 2014. And that was no fluke, as it has consistently earned more than 20% on its equity every year since 2010. Meanwhile, according to the FDIC, the average bank in the United States earned less than 9% on its capital base last year.

For credit card loans to be profitable, however, their risk must be offset by an adequate return from fees and a high interest rate on unpaid balances. To circle back to Costco, in turn, it's presumably here where the retailer and American Express couldn't see eye to eye -- although they also could have been at odds over the percentage of Costco customers who weren't approved for a card (this is pure speculation on my part).

With this in mind, it's telling that Costco selected Citigroup(NYSE:C) to replace American Express as the portfolio's underwriter. I say that because Citigroup has consistently demonstrated a more lackadaisical approach to credit risk than American Express has. Since the eve of the financial crisis, for instance, a vastly larger share of Citigroup's net revenue has been consumed by loan loss provisions relative to American Express's.

This is a revealing indictment of Citigroup's risk management. It also seems to shed light on why Citigroup was more amenable to Costco's terms than American Express was. Citigroup needs every win it can get nowadays, and it's evidently willing to sacrifice margin to secure one -- this is presuming that sacrificing margin was in fact necessary to consummate the partnership, which I believe to be a fair presumption in light of Costco's modus operandi vis-a-vis suppliers. American Express, on the other hand, doesn't have to be similarly desperate. As Chenault noted, "We will invest in other opportunities that we think can generate greater returns over time."

At the end of the day, great lenders differentiate themselves by saying "no" when less circumspect competitors are willing to say "yes." That's the moral of this story. If American Express didn't believe that renewing the Costco partnership made economic sense, then it probably didn't. Thus, even though it may not seem like it on the surface, American Express' widely unpopular decision serves as potent evidence of its prudence and commitment to maximizing long-term value for its shareholders.

John Maxfield has no position in any stocks mentioned. The Motley Fool recommends American Express and Costco Wholesale. The Motley Fool owns shares of Citigroup Inc and Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.